Transfer Pricing - part b of June 2014 Q

I assume that you have watched my free lectures on transfer pricing and are therefore happy that the minimum transfer price will be the marginal cost plus any lost contribution, and that the maximum transfer price will be the lower of the net marginal revenue and any external purchase price. C is currently making sales of 8,010,000 and the question says that this is 60% of the demand externally. This means that the total demand externally must be 8,010,000/60% = 13,350,000. So if they were not selling to the other division they could sell an extra 13,350,000 - 8,010,000 = 5,340,000 externally. Therefore if they do sell them to the other division they will need to charge the other division at least 5,340,000. At the moment they are selling to the other division a total of 7,550,000 and these are all being sold at the external selling price. For 5,340,000 of them, this is fine (as explained above). However the remaining 2,210,000 could not be sold externally because there is not the demand, and so they could be transferred at the marginal cost of production. 2,210,000 is the external selling price, but the question says that variable costs are 40%, so the marginal cost of these is 40% x 2,210,000 = 884,000. Therefore the minimum total transfer price is 5,340,000 + 884,000 = 6,224,000. The maximum transfer price is the Gearbox divisions external purchase price which is 95% x 7,550,000 = 7,172,500

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